Samuel C. Thompson, Jr., Professor and Director of the Center for the Study of Mergers and Acquisitions, University of Miami School of Law; Effective January 2002, Professor and Director of the Center for the Study of Mergers and Acquisitions, UCLA School of Law, samuel_thompson@hotmail.com.

I Background

On October 22, 2002, the SEC promulgated a Proposed Rule regarding Disclosure Required by Sections 404, 406, and 407 of the Sarbanes-Oxley Act of 2002 (the Act). Comments are to be submitted before November 29, 2002. This comment, which is being submitted by email pursuant to the instructions in the Proposed Rule, focuses only on the Code of Ethics provisions of the Proposed Rule.

II Code of Ethics for Chief Executive Officer as Well as Chief Financial Officer and Directors

The Proposed Rule asks whether the Code of Ethics provision should extend to the chief executive officer as drafted or should be limited to the chief financial officer as specified in Section 406 of the Act. Also, the Proposed Rule asks if a company should be required to disclose whether it has a Code of Ethics that applies to directors. It is sensible to extend the disclosures with respect to the Code of Ethics to the chief executive officer and to the other senior executives, at least those that are members of the board. Further, there are sound reasons for extending the provisions to the directors generally.

The provision should apply to any person who is in a position within a corporation that could give rise to the type of conflict of interest at which the provision is directed, that is, "actual or apparent conflicts of interest between personal and professional relationships." Although Section 406 requires the SEC to adopt disclosure rules regarding the Code of Ethics for senior financial officers, the statute does not prohibit the SEC from adopting such rules for other executives or for directors. In view of the events leading up to the enactment of the Act, it would appear that disclosures with regard to a Code of Ethics would be material, and for that reason, it is appropriate for the SEC to extend the disclosure obligation to the chief executive officer, as drafted, and also to other senior executives who are members of the board. In addition, it should be extended to directors generally. Indeed, it is more important for the provision to apply to the board than to the chief financial officer, because a board member is in a position that could give rise to greater conflicts of the type at which the act is directed. If the provision is extended to the board generally, it would not be necessary to extend it to other executives who are members of the board.

III Application of Code of Ethics in Change of Control Transactions

Many conflicts of interest can arise in various types of change of control situations, including conflicts between the interests of the executives of the target and the target's shareholders and conflicts between the interests of the executives of the acquiror and the acquiror's shareholders. Further, conflicts arise in various types of going private transactions, such as short form mergers.

The state corporate law has not been successful in addressing many of these conflicts. For example, the Delaware Supreme Court recently held in Glassman v. Unocal Exploration Corporation, 2001 Del. LEXIS 317, that the entire fairness test, which requires proof that a merger between a controlling shareholder and a partially owned sub is entirely fair, does not apply in a short form merger. This means that a controlling parent corporation can pay whatever it wants in a short form merger and the only remedy the minority shareholders of the sub have is to have their shares appraised. There is no requirement that an independent committee of the sub's directors negotiate with the parent over the transaction. The appraisal remedy in many aspects inefficient, and as a practical matter, this decision will work to the disadvantage of a sub's shareholders in a classic conflict of interest situation.

The proposed rule should be amended to require specific disclosures regarding whether a corporation's Code of Ethics, if any, governs conflicts of interest that can arise in various types of change of control transactions. The provision should be written broadly enough to apply to both acquirors and targets in third party transactions and to all types of interested party transactions, including short form mergers. This could help to alert boards and executives to the need to be particularly vigilant in addressing any "actual or apparent conflict of interests" that may arise in the context of a change of control transaction.

IV Relationship to Audit Committee Rules

Section 301 of the Act adds Section 10A(m)(1)(A) to the Securities Exchange Act of 1934, which directs the SEC to promulgate (within 270 days from the date of enactment) rules requiring the securities exchanges and associations, such as the New York Stock Exchange and NASDAQ, to prohibit the listing of any security of a company that is not in compliance with certain rules regarding the audit committee of the company's board of directors. In the attached draft paper, Addressing Conflicts Of Interest In Mergers And Acquisitions Through The Sarbanes-Oxley Act of2002, September 5, 2002, I argue that the SEC should promulgate rules under the Sarbanes-Oxley Act requiring the audit committee to take an active role in scrutinizing the financial and economic aspects of any merger or acquisition a firm engages in either as an acquiror or a target. I intend to file a revised copy of this paper prior to the publication of the proposed audit committee rules.

By adopting suggested rules relating to audit committees and also adopting the rules suggested above relating to Codes of Ethics, the SEC would go a long way to eliminating conflicts of interest in the change of control market, thereby making this market more economically efficient.

Draft September 5, 2002

ADDRESSING CONFLICTS OF INTEREST IN MERGERS AND ACQUISITIONS THROUGH THE SARBANES-OXLEY ACT OF 2002

BY

SAMUEL C. THOMPSON, JR.*VISITIING PROFESSOR UNIVERSITY OF VIRGINIA SCHOOL OF LAW (FALL 2002)
AND
PROFESSOR AND DIRECTOR
CENTER FOR THE STUDY OF MERGERS AND ACQUISITIONS
UNIVERSITY OF MIAMI SCHOOL OF LAW

I Background

The recent events involving Enron, WorldCom, and Global Crossing, each of which is in bankruptcy, demonstrate that the boards of publicly held U.S. companies often have not adequately addressed conflicts of interests they encounter. The Sarbanes-Oxley Act of 2002 ("the Sarbanes-Oxley Act" or "the Act"),1 which was signed into law by President Bush on July 30, 2002, addresses these conflicts in many ways. One provision of the Act directs the Securities and Exchange Commission (SEC) to promulgate (within 270 days from the date of enactment) rules requiring the securities exchanges and associations, such as the New York Stock Exchange and NASDAQ, to prohibit the listing of any security of a company that is not in compliance with certain rules regarding the audit committee of the company's board of directors.2

The central feature of this provision of the Act, which adds Section 10A(m) to the Securities Exchange Act of 1934 (the "34 Act"), provides that the audit committee "shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or related work, and each such registered public accounting firm shall report directly to the audit committee."3 Each member of the audit committee must be "independent,"4 and specific guidance is given for determining if this independence standard is met.5 Further, the audit committee has the authority to "engage independent counsel and other advisers, as it determines necessary to carry out its duties,"6 and each issuer is required to provide "appropriate funding . . . as determined by the audit committee" for payment of compensation to the registered public accounting firm and any advisers.7 In addition, the SEC is required to promulgate rules requiring companies to disclose in their periodic reports whether or not (and if not, why not) at least one member of the audit committee is a "financial expert," a term that is to be defined by the SEC.8

Section II explains how the audit committee provisions of the Sarbanes-Oxley Act build upon a previous proposal for federalization of certain aspects of corporate law, and Section III discusses the manner in which current state law deals with various types of conflicts of interests that can arise in mergers and acquisitions. Section IV reviews a proposal I have made for the adoption by Congress of a Change of Control Board concept for publicly held target corporations as a mechanism for addressing conflicts of interests arising in various types of mergers and acquisitions, and Section V proposes extending the Change of Control Board concept to acquiring corporations. Section VI explains how many of the concepts underlying the Change of Control concept can be implemented by the SEC through its rulemaking authority under the audit committee provisions of Sarbanes-Oxley Act. Finally, Section VII provides a conclusion.

II Sarbanes-Oxley's Federalization of One Aspect of Corporate Law: Moving Closer to Professor Cary's Position

The audit committee rule set forth in the Sarbanes-Oxley Act are in addition to the existing rules governing such committees promulgated by the exchanges or set out in state corporate law relating generally to board committees.9 Thus, these audit committee rules represent a federalization of an aspect of the fiduciary law governing a corporation's directors.

Indeed, the Sarbanes-Oxley Act moves us one step closer to the position of the late Professor Carey, a former Chairman of the SEC and a leading professor of corporate and securities law. In a famous 1974 article,10 Professor Cary argued that Delaware's legislature and courts in an effort to attract corporations to that state were engaged in a "race to the bottom" by not providing adequate protection of shareholders. He, therefore, proposed that Congress adopt uniform Federal standards for publicly held corporations governing such issues as the fiduciary duties of directors and the rules governing interested directors. By enacting the audit committee provisions of the Sarbanes-Oxley Act, Congress has built upon Professor Cary's proposals, and rejected the argument of Professor Fischel and other Chicago school corporate scholars. For example, Professor Fischel has written that "[Professor] Cary's position has been discredited; indeed in recent years it has been discussed only as an illustration of how it is possible to reach the wrong conclusions if one lacks a basic understanding of the economic structure of the corporation and of corporate law."11 In enacting the audit committee provisions, Congress has expressly rejected Professor Fischel's view of Professor Cary's position, and it would appear that in their reaction to the disclosures concerning Enron and other problem companies, the capital markets have also rejected this view of Cary's position.

III M&A Conflicts Not Directly Reached by Sarbanes-Oxley: The Bizarre State of State Takeover Law

While the conflicts of interests that are the focus of the Sarbanes-Oxley Act relate principally to ongoing operations, courts have been wrestling for years with conflicts of interests arising in mergers and acquisitions (M&A).

Since many publicly held corporations are incorporated in Delaware, the starting point in understanding this issue is to look at the current state of Delaware M&A law governing the directors of a target corporation.

In the famous Unocal12 case, which involved the defensive tactics undertaken by the board of Unocal in an attempt to defeat a hostile bid by T. Boone Pickens, the Delaware Supreme Court adopted an "enhanced business judgment rule" for determining if a target's board has acted properly. There the court said: "Because of the omnipresent specter that a [target's] board may be acting primarily in its own interests, rather than those of the corporation and its shareholders, there is an enhanced duty which calls for judicial examination at the threshold before the protections of the business judgment rule may be conferred."13

This means that under Delaware law because of the potential conflicts of interest the target's board faces in a hostile tender offer, the board does not get the benefit of the normal "business judgment rule," pursuant to which the judiciary generally gives deference to a board's decisions. This rule, which is available in arm's length negotiated mergers, is a "presumption that in making a business decision the director of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company."14 If this presumption applies, it is unlikely that a plaintiff, who has the burden of proof, can successfully challenge the action of a board, unless the plaintiff can establish that the board was "grossly negligent," a standard that was set out in the Van Gorkom15 case. And, even if the board is grossly negligent in approving a merger for an inadequate price, the shareholders generally cannot recover damages from the directors because Delaware law and the law of other states permit corporations to shield their directors from liability for breaches of the duty of care (that is being grossly negligent) as long as they have no interest in the transaction and otherwise act in good faith.16 On the other hand, in hostile tender offers, the Unocal standard applies, and the target's board itself has the burden of establishing that it had a reasonable basis for perceiving a threat from the hostile bidder and that its defensive response was reasonable in relation to the threat posed.

Although there may be "soft" conflicts in arm's length negotiated mergers, such as negotiations by the CEO of a golden parachute for herself at the same time she is negotiating what looks like an arm's length merger, the Delaware courts usually apply the business judgment rule in these mergers. Also, the business judgment rule will almost certainly apply to the board of the acquiring corporation.17 On the other hand, in a management buyout or going private transaction, where the acquiring party is on both sides of the transaction and, therefore, involved in an inherent conflict of interest, the Delaware courts normally apply the "entire fairness" standard of review.18 Unless disinterested directors approve the transaction, this standard requires the acquiring party to prove that the transaction is entirely fair, which is a heavy burden.19 On the other hand, if disinterested directors or a majority of minority shareholders approve the transaction after full and candid disclosure, the burden of proving the transaction is not entirely fair shifts to the plaintiff.20

Thus, Delaware law applies different standards of review depending on the type of transaction the target's board faces, and these different standards lead to substantial litigation in M&A transactions. As illustrated in a recent article written by three Delaware judges,21 the current law is not clear in all respects and is, in their view, in need of reform that would generally increase the deference given to "disinterested directors."

The boards of corporations incorporated in many states, such as Pennsylvania and Oregon, where Enron is incorporated, receive even greater protection for their actions than under Delaware law, particularly in the context of hostile tender offers. Further, in states like Pennsylvania and Georgia, a target's board can issue a poison pill (i.e., options that make it prohibitively expensive for a target to be acquired in a hostile transaction) that only the board or its designees can redeem.22 These "dead hand" pills are illegal in Delaware.23

As illustrated above, the board of directors of a target corporation can face a conflict of interest in all types of M&A transactions. Further, even if "disinterested directors" act for the target in any of these transactions, as Enron demonstrates, it is difficult to determine if "disinterested directors" are truly disinterested. Thus, it seems that the Delaware judges who have suggested giving additional deference to "disinterested directors" are pointing the law in the wrong direction.

Moreover, because the standard of review applied to directors' actions depends on the state in which the target is incorporated, absurd results can occur as indicated in the Chesapeake case.24 There, a Delaware corporation made a hostile offer for a Virginia corporation. However, under Virginia takeover law, the Virginia corporation was in essence takeover proof, even though the directors had a clear conflict of interest in employing defensive tactics that entrenched themselves. The Virginia corporation then made a hostile bid for the Delaware bidder, which undertook defensive tactics. The Delaware court, applying the enhanced business judgment rule, found those tactics to be inappropriate in view of the directors' obvious conflict of interest. The end result is that in our Federal system, without regard to the conflicts faced by both sides, a Virginia corporation may be able to takeover a Delaware target, but a Delaware corporation cannot, without the target's consent, takeover a Virginia target.

IV Need for an Independent and Knowledgeable Change of Control Board for Publicly Held Target Corporations

In my article, Change Of Control Board: Federal Preemption Of The Law Governing A Target's Directors,25 I propose that Congress address the conflicts of interest in all types of M&A transactions by requiring the independent appointment of a disinterested board for any publicly held corporation that becomes the target of a merger or acquisition. Under this proposal, once a public corporation becomes a target of a bona fide merger or acquisition offer, a Change of Control Official, who would be an employee of the SEC, would appoint a three-person independent and knowledgeable Change of Control Board for the target. The determination of independence would be made pursuant to rules promulgated by the SEC, and these rules would be more stringent than the view of independence followed by Delaware corporate law. The Change of Control Board would have the authority to hire its own counsel, investment banker, and other advisers, and the corporation would be required to provide the funding pursuant to SEC regulations.

The Change of Control Board would have complete authority over the acquisition process, and because of its obvious independence, it would be expected to act in the best interest of the corporation and the shareholders. Therefore, a Federal uniform standard of review, the business judgment rule, would apply in determining if the board acted properly. Application of this standard would significantly reduce litigation associated with M&A transactions.

This proposal would replace the several standards of review applicable to a target's directors under Delaware law and would also override all state takeover laws, like those in Pennsylvania and Oregon.

By placing the control of the M&A process in the hands of truly disinterested directors and applying the business judgment rule in all cases in which a Change of Control Board acts, this proposal would significantly enhance the efficiency of the M&A marketplace.

Many features of the Change of Control Board concept are similar to those provided for audit committees in the Sarbanes-Oxley Act. The Change of Control Board, however, would be appointed by an SEC official, rather than the corporation's board, which selects the audit committee. Therefore, the Change of Control Board would likely have a more certain degree of independence.

I propose that as a next step in its action on corporate governance that Congress adopt this Change of Control Board concept.

V Applicability of Change of Control Concept to Acquiring Corporations

Although as proposed the Change of Control Board concept only applies to target corporations in M&A transactions, the concept could be extended to acquiring corporations. For example, approval by a Change of Control Board of an acquiring corporation could be required for any significant acquisition the acquiror proposes to make, such as the acquisition by WorldCom of MCI.

Numerous financial studies show that the shareholders of acquiring corporations often realize losses on the announcement of an acquisition (which means that the market perceives the transaction as a negative present value transaction for the acquiror).26 This could result, inter alia, from an overpayment by the acquiror attributable to the hubris of its managers or the desire of its managers to enhance their compensation by operating a larger firm. This potential tension between the interest of the acquiror's managers and the interest of the acquiror's shareholders is another illustration of the conflicts of interests that can arise in the M&A context. Prior approval by a Change of Control Board of an acquiror for significant acquisitions could reduce the number of such transactions in which the acquiror's shareholders realize losses.

VI Potential for Active Role for Audit Committees Under the Sarbanes-Oxley Act in Change of Control Situations

It would appear that the SEC, through its rules issued under the audit committee provisions of the Sarbanes-Oxley Act, has the authority to require the audit committee to serve many of the functions of a Change of Control Board.

The Sarbanes-Oxley Act provides that audit committees are to have broad "oversight of the work of any registered public accounting firm employed by the issuer . . . for the purpose of preparing an audit report or related work . . . "27 The SEC in its rules should clarify that the concept of "related work" encompasses the preparation of any financial information, whether audited or not, related to an acquisition in which the issuer is involved as either an acquiror or a target. Further, since each audit committee has the authority to "engage independent counsel and other advisers, as it determines necessary to carry out its duties,"28 the SEC should make clear in its rules that in connection with its review of an acquisition, an audit committee has the authority, where it deems appropriate, to retain its own counsel, investment banking firm, and other advisers for the purpose of reviewing all financial information related to the acquisition, including the fairness opinion and financial arrangements between the acquiror and managers of the target.

In essence, the language of the audit committee provision is broad enough to give the audit committee a significant role in determining if the financial and economic case for a merger or acquisition has been made by the target's management. In this connection, the SEC's rules should require that the audit committee take a position on the financial impact on:

(1) the shareholders of the target in any arm's length transaction,

(2) the shareholders of the target in a hostile offer of any defensive tactics that the target's board may consider undertaking,

(3) the shareholders of the target in any interested party transaction, such as a parent sub merger or management buyout, and

(4) the shareholders of the acquiror in respect of any major acquisition the acquiror intends to undertake.

Also, the SEC's rules should make it clear that audit committee approval is needed before a target's board can undertake any defensive action, such as the adoption of a poison pill, including a "dead hand" pill or any other defensive measure that may be permitted by a state's anti-takeover statute.

By adopting this approach in its audit committee rules, the SEC could provide an added check on management of both targets and acquirors in the acquisition context, thus enhancing the economic efficiency of the market for corporate control. Further, such action would make it more likely that the directors in all types of mergers and acquisitions will have clearly fulfilled their duties of loyalty, care, good faith and disclosure. As a consequence, it would be possible for Delaware and other states to extend business judgment rule protection to any board actions taken with the approval of the company's audit committee, whether involving an arm's length merger or acquisition, the use of defensive tactics, or an interested party merger, such as a parent sub merger or a management buyout. This would significantly reduce the amount of merger and acquisition litigation, since it effectively avoids the application of Unocal's enhanced business judgment rule and the entire fairness test. Instead, actions would be evaluated under the more judicially deferential business judgment rule.

If the SEC concludes that it does not have the authority to go this far, and Congress does not adopt the Change of Control Board concept, Congress should consider amending the Sarbanes-Oxley Act to make such authority clear.

VII Conclusion

As the next step in its action regarding corporate governance, Congress should address the conflicts of interests arising in mergers and acquisitions by adopting the Change of Control Board concept for both targets and acquirors. As an alternative, the SEC should promulgate rules under the Sarbanes-Oxley Act requiring the audit committee to take an active role in scrutinizing the financial and economic aspects of any merger or acquisition a firm engages in either as an acquiror or a target.

I want to thank my research assistants, Robert Clary, of the University of Miami School of Law, and Peter Gilman, of the University of Virginia School of Law, for their helpful comments on this article.